How to Value a Law Firm
When you’re just getting your law firm off the ground, the idea of needing to value your practice may sound ludicrous.
Because you’re not looking to sell anytime soon, so why would you need to conduct a law firm valuation, right?
But there are actually several reasons for valuing your law practice, such as a firm merger, securing loan financing, adding new partners, and many other business matters, including, of course, selling. While those scenarios may not be on the table yet, it’s a good idea to know how to go about the valuation process before needing to undertake it. After all, you never know what life may throw your way that could change your plans (looking at you, COVID). Not to mention that the process of valuing your practice should be part of any succession/exit strategy.
Having an idea of how to go about valuing your firm will put you ahead of the game when the time comes.
The first thing you should know is that there is no one-size-fits-all way to value a law firm. Now, you might be thinking this sounds tedious and time-consuming, but fear not. We’re here to help. We’ve put together some tips to help you understand the process of valuing your law firm.
Let’s get to it.
If you’re thinking you’d handle the business of valuing your law firm yourself, you’ll probably want to reconsider that. “But I know my firm’s billed hours and costs; how hard can it be?” In a word: very.
Law firm valuations can differ from typical business appraisals and are often more complicated.
For example, one potential complication is that clients might be more loyal to a specific lawyer than the actual overarching law practice, and some of those clients may follow a partner who leaves the firm. And that would impact the value. (We’ll dive more into this situation in a little bit.)
Since every law firm is different, the individual characteristics of your practice will need to be considered as part of the valuation process. While some of these factors will increase the value of your law firm, others may lower it. Factors like growth potential, brand identity, size of practice, fee structures, and geographic location, just to name a few, can cause a valuation swing in either direction.
What’s more, for many law firm owners, accurately determining their practice’s value can be a struggle because of the time, energy, and money invested, which can create a false sense of heightened value.
All of this is to say that the complications that arise during a valuation process demand the expertise of an outside source to help value your law firm, including analyzing subjective factors. So, it’s best to hire a valuation specialist to appraise your practice.
A word of advice: make sure the professional you hire has experience valuing law firms similar to yours (think size, area of expertise, geographical location).
You’ve put a lot of blood, sweat, and tears into building your practice (though hopefully not literally). And since you’ve put so much time and effort into establishing and growing your law firm, you want to make sure that its valuation reflects your investment.
One way to ensure this is by improving your firm’s financial well-being before undertaking a valuation process – especially if you intend to sell since this will make your firm more attractive to potential buyers.
Think about the feedback you have received from employees and clients; are there areas you could improve upon to increase your firm’s value?
Implementing new technology to streamline and enhance operations is one key way to increase the value of your law practice. For example, legal practice management software can improve your firm’s efficiencies and optimize workflow. Plus, leveraging legal technology shows your firm’s willingness to adapt and embrace new trends.
Did you know that a report by McKinsey Global Institute found that existing technology could automate 23% of lawyers’ workloads? Or that lawyers spend nearly 40% of their day on tasks other than practicing law? Utilizing legal technologies that free up time spent on administrative tasks can help add more billable work, thereby increasing your firm’s profits – and, you guessed it, its value.
Have you ever visited a small business and thought: “It just hasn’t been the same here since the old owners left”?
The service isn’t quite what you were used to, and you miss your personal connection with the former owners.
That reflects what’s known as goodwill, and it can play a significant role in the valuation of your firm.
In an article for the ABA, Dale Lash, partner-in-charge of RubinBrown’s Business Valuation Services Group in Denver, explained: “Fixed assets – equipment, furniture – those are relatively easy to value. Goodwill – that is the intangible asset that you’re really looking at because that is what a lawyer or professional services firm is transferring. Goodwill, if there is any value in it, flows from the ability of the seller to successfully transfer a book of business to the buyer.”
There are two types of goodwill. The first is practice goodwill, which refers to a law firm’s brand recognition, client base, business relationships, existing procedures, and other intangible assets that impact the practice’s overall value as an entity.
There is also personal goodwill (also known as professional goodwill), which is the value derived from an individual lawyer’s efforts, expertise, and reputation at a law firm. The issue is that while practice goodwill is transferable, personal goodwill is not.
Say the dentist you have been seeing for the last ten years decides to leave the clinic they are with to start their own practice. Would you follow them or stay at the current clinic with a new dentist? If you’d choose to follow the dentist, that’s a reflection of the dentist’s personal goodwill.
And the situation is no different in the legal world.
Many people will consider themselves the client of an individual lawyer rather than a client of the firm where the lawyer works. It comes down to whether clients are attracted to the law firm or a specific lawyer for service – do they consider that they are hiring the firm or the individual lawyer?
The truth is that many law firms have more personal goodwill compared to practice goodwill. If this scenario rings true for your law firm, it may be a good idea to find ways to improve your firm’s commercially-transferable goodwill. One option would be to ensure that each client has more than one point of contact within the firm.
While goodwill can be a crucial part of the valuation process, measuring it is easier said than done. According to the ABA article mentioned above, an earnings multiplier is a common approach for goodwill valuation, though determining it is a subjective process (as in, have an experienced appraiser help out).
Time to get down to the brass tacks of how to value a law firm.
As mentioned already, there’s no absolute “right” way to value a law firm. But every law firm does have value.
There are various valuation methods available, and each has its pros and cons. Depending on the circumstances and reason for valuation, an appraiser will likely use a combination of the following methods to determine your firm’s value:
Rule of Thumb
The rule of thumb approach is a common method used to value a company. This simple method takes one year’s gross revenue and multiplies it by a particular factor. In the legal field, the multiplier range tends to be 0.5 to 3.0.
Whether the multiplier is in the high or low end of the range depends on various factors, such as:
Field of legal practice (Is the practice area in a new or growing field that’s becoming more in demand?)
Number of clients
Amount of repeat business
Geographic location
Is the rule of thumb method exact? Definitely not, but it can provide a good starting point in the valuation process.
Asset-Based Approach
The asset-based valuation method uses what some call “deceivingly simple math.” If that doesn’t sound like a resounding endorsement, that’s because the asset-based approach generally isn’t favored for law firm valuation.
For the asset-based method, a firm’s assets are tallied and its liabilities subtracted, leaving a net value. The problem is that the narrow focus of this valuation method ignores a law firm’s earnings and cash flow, which are two of the quintessential indicators of a firm’s financial health.
Market Comparison
Next up is a valuation approach that compares your law firm to competing or very similar law practices that have sold.
The premise of the market comparison approach is that what a law firm around the corner sold for the other week should be approximately what your practice would sell for today, providing they are similar in financials and main characteristics.
That sounds straightforward enough, but this approach has a significant drawback: information on law firm sales is tough to find. There isn’t a public database of closed transactions, and most negotiations are confidential. What’s more, even if your appraiser finds out the sale price of a comparable law practice, they still wouldn’t know the unique circumstances behind that sale that impact the value.
This isn’t to say that a market comparison isn’t useful for valuing a law firm. Data from comparable law firm sales can be helpful to supplement other valuation methods.
Discounted Cash Flow
Lastly is what some refer to as the preferred valuation approach.
The discounted cash flow method is based on a law firm’s future revenues rather than historical performance. The method involves estimating a firm’s future cash flows (often based on financial statements from the last five years) and applying a growth rate to approximate a terminal value at the end of a set period. The cash flows and terminal value are then discounted to their net present value. Essentially, the method determines the projected rate of return on future cash flows.
The good news with this approach is that law firms can usually reasonably project future cash flows since law practices tend to be stable-growth enterprises. But, of course, there still are some drawbacks. For example, this approach only considers future cash flows and doesn’t factor in any unique circumstances or considerations about the law firm being valued. Plus, the entire premise of this valuation method is based on assumptions, which could backfire.
As mentioned earlier, even if the need to value your law firm is not yet on your radar, it’s worthwhile to know about the process for when the time comes.
We can’t tell you that valuing your law firm will be the easiest task. And the valuation process isn’t something that will happen overnight. The process requires a substantial amount of time and work, but that will ensure your firm receives the maximum valuation possible. (Plus, remember that you don’t have to do it alone if you hire a valuation specialist.)
Regardless of what valuation method is used, the bottom line is that your law practice does have value. So make sure to be proactive and diligent in valuing the law firm you have worked so tirelessly to build.
